Choosing a Liquidity Pool to Dive Into
The things you need to know when choosing the right pool for your crypto assets.
Liquidity pools have become an essential part of decentralized markets in crypto. However, the ideas and mechanisms behind them are complex — and finding a pool that offers good results while minimizing the risk of losses is often a challenge.
This article consists of two parts.
In the first part, I answer the most important questions about liquidity pools and also share my recommendation for a liquidity pool (GIGA Pool) you should check out.
In the second part, I show you step-by-step how to research liquidity pools.
Let’s start with the basics first.
Part 1 — Everything You Need To Know About Liquidity Pools
What is a liquidity pool and how does it work?
A liquidity pool is a collection of funds locked in a smart contract. Users who add an equal value of two tokens (for example ETH/USDC) in a pool to create a market are liquidity providers.
One can think of each liquidity pool as a separate market for this specific pairing of tokens. In exchange for providing funds, liquidity providers earn trading fees from the trades that happen in their pool, proportional to their share of the total liquidity.
Here is a simplified graphic I made to visualize how liquidity pools work (it’s not pretty but it should do the job).
Why are liquidity pools needed?
On centralized exchanges, so-called market makers create liquidity in the market by always buying or selling a specific holding of a cryptocurrency. This means retail investors can find a buyer/seller without delay.
However, traditional market makers do not work in DeFi (decentralized finance). For example, on Ethereum, where many DeFi transactions take place, 12–15 transactions per second. This means that traditional market makers in DeFi would result in an unusable platform that is overpriced and outrageously slow. This is why liquidity pools were invented — they provide liquidity to decentralized exchanges.
What different kinds of liquidity pools are there?
A distinction is made between three types of liquidity pools:
- The ‘standard’ variant mentioned at the beginning, for which users provide two assets in a 50:50 ratio.
- Single-sided liquidity pools, where you can provide liquidity on only one side instead of having to split the funds evenly 50:50.
- Flexible liquidity pools that do not require a 50:50 coin or token ratio to determine the exact price of a supported asset. Some of them offer ratios like 80:20, 60:40, or other variants.
What makes liquidity pools exciting is the opportunity to make money from them. In the following, I will show exactly how this works.
How can I earn money with liquidity pools?
Put simply, you get paid for making your assets available in pools — a process also called liquidity mining or yield farming. It usually involves the following steps:
- Go to the DEX platform with the pool you want to provide liquidity for and connect your wallet.
- Deposit the amount you want for the pair to confirm the supply. The amount of the cryptocurrency or token deposited should be equivalent to the amount for the other coin of the pair.
- When providing liquidity, you will receive liquidity provider (LP) tokens in proportion to the funds you added to the pool’s total liquidity. LP tokens are needed to redeem the funds locked into the liquidity pool’s smart contract.
- As long as your assets remain in the pool, you will earn a certain percentage when other users use the assets provided by you.
Note: There are two ways in which fees are being paid out. Depending on the protocol, they are either paid out in-kind, meaning in one of the currencies or tokens you originally added to the pool. Some DeFi-platforms also pay out generated fees in their native token (often a governance token). - On top of the fees, some DeFi-platforms also pay out some of their native tokens as a reward for liquidity providers who participate in specified pools.
- In many cases, you can then deposit the LP tokens and native tokens to other liquidity pools to earn rewards there.
- To take out your assets from a pool, you have to redeem them by using the LP token. In exchange, you will receive both the fees and the farmed native tokens.
To maximize yields, some users move around their assets a lot between different platforms and pools. However, yields can vary significantly, depending on the protocol, the specific pool, the deposited coins and tokens, and overall market conditions.
What is the difference between liquidity pools and staking?
Liquidity pools are often confused with staking, but there’s a big difference. When staking, you place the tokens in a specific location to secure the network (Proof of Stake) and usually receive transaction fees and/or block rewards for doing so. Liquidity pools, on the other hand, were invented with the sole purpose of lending out your tokens to provide liquidity to the market.
Why should I put my funds into a liquidity pool instead of other options such as staking?
Staking is a means of achieving proof of stake consensus. The rewards of staking are distributed on-chain, which means every time a block is validated, new tokens of that cryptocurrency are minted and distributed as staking rewards.
In comparison with staking, rewards for liquidity providing are often higher and hence a much more attractive option for individuals who would like to put their idle assets to work.
What are the risks of liquidity pools?
Impermanent loss
Impermanent loss might be the biggest concern to a liquidity provider. As explained previously, the tokens you provide to a liquidity pool are paired according to the asset value when you initially participate. This means that any movement of the ratio of the pair will result in impermanent loss, which will damage the return you can get. The higher the price divergence of the token, the more impermanent loss will be suffered.
To get a better understanding of how ratio changes affect impermanent loss, check out this impermanent loss calculator.
So far so good. But why is it called impermanent loss? The name is somewhat misleading. That’s because the losses only become realized once you withdraw your assets from the liquidity pool. At that point, however, the losses become permanent.
Smart contract risk
The funds you deposited into a liquidity pool are no longer in your own wallet. The contract acts as the custodian of the funds when there are no middlemen involved. So, be aware of any bug or chance of exploit which may lead to loss of funds.
Scams
It’s always important to DYOR to better understand the project. Be mindful that some developers may have permission to change the rules governing the pool. If developers can have an admin key or some other privileged access within the smart contract code, they can potentially take control of the funds in the pool. And there might be chances of malicious activities, like rug pulls and other exit scams.
What can I do against impermanent losses and other risks?
Avoid volatile liquidity pools
Most crypto assets are very volatile. Their value fluctuates based on market demand. Smaller coins and tokens have higher chances of experiencing massive intraday price swings, making them much riskier in terms of temporary losses.
As a consequence, you can focus on pools for large caps such as BTC and ETH. An alternative would be to choose a stablecoin asset pool. These US dollar-pegged coins do not fluctuate as much as other crypto assets. Then there are other stable assets like sETH and stETH pegged to ETH, and WBTC and renBTC pegged to BTC.
Use single-sided or flexible pools
The following chart shows how flexible liquidity pools reduce impermanent loss when compared to the standard 50:50 pools — although it must be noted that this of course always depends on the specific performance of the underlying assets. For example, at a 95:5 ratio, the impermanent loss is significantly smaller than with an 80:20 ratio.
Join the liquidity pools of renowned platforms such as hi
Large operators of liquidity pools put a very strong focus (and a lot of their resources) on security. For example, the team behind the crypto platform hi has implemented multiple tactics to ensure high-level cybersecurity on all products and services — including their liquidity pools. The platform’s native token is HI. For more information about hi’s security, please check out their whitepaper.
hi’s GIGA Pools have 200 Million HI allocated as rewards to its liquidity providers (100M HI each for BSC + ETH pool). Your share of the 200 Million HI rewards is calculated based on your percentage share of the overall liquidity pool according to the APY and the number of LP tokens you have staked at any time. As the APY will fluctuate depending on how many participants and LP tokens are in the pool, you can check the latest APY and participate at stake.hi.com. As of now, the APY is still about 770% up for the ETH GIGA Pool and 490% up for the BSC GIGA Pool.
If it’s the first time you participate in a liquidity pool, you can watch their tutorial here.
Download the d hi App on your mobile phone (iOS or Android) or head to web.hi.com to get started. My hi nickname is renheinrich if you need a referral nickname.
Part 2 — A Step-by-Step Guide To Research Liquidity Pools
When researching liquidity pools, there are multiple things you need to take into account. In general, you want to rely on the latest data and dig up every piece of information that contributes to the platform’s credibility. Naturally, the platform’s website and whitepaper are the primary sources.
But while doing so it’s important to cut through the marketing fluff and focus on what matters. Every DeFi platform will try to lure you in by promising high APYs. Nothing wrong with that as it’s one of the main selling points. Just keep in mind that other factors count as well. And a lot of that info you can find in 3rd party sources.
But what are the actual points you need to consider when researching a pool? There are two main areas you’d want to focus on — the platform and the individual pools. Let’s go through them one by one.
Researching the DEX
Security
Keeping your funds safe should be one of your primary concerns. Look into and understand the measures implemented by the platform to provide maximum safety.
- Look for information on the technological solutions they use, ISO certifications, interviews with their CSO (chief security officer), etc.
- Look for smart contract audits undertaken by an external provider.
- As already mentioned, large and well-known platforms like Uniswap, Binance, and hi carry a much lower risk than small and still relatively new platforms. So if you’re new to this area of crypto, you probably want to stick with one of the renowned providers.
Payout process
Another big one.
- How does the platform pay out the fees?
- Does it happen in-kind or as a native token?
- What’s the exact process — can you immediately access your returns or only after you have taken out your initial funds from the pool?
Stuff like these is important to know before you start locking up your assets so you avoid bad surprises.
Use case and tokenomics for the native token
Many platforms pay you in their native tokens. Try to find answers to the following questions:
- What’s the total supply and is there a hard cap? You want a relatively low supply that is hard-capped.
- Is there a timetable for the distribution of the tokens?
- What are the utilities? Many platforms use it as a governance token which might be very valuable if the project is successful and there’s no other way to get it except by participating in their pools.
- How are the tokens distributed? Only to liquidity providers or do they hand a lot of it out for free as part of airdrops? You’d want something that is scarce and hard to get.
Researching tokenomics is a whole topic in itself. Read my free guide here to get an in-depth overview of the things you need to know.
The team behind the platform
Find out whatever you can about the team behind the project. Find answers to the following questions:
- Who are they and what is their track record?
- Do they openly share who they are (f.e. linking to their LinkedIn profiles)?
- Take note, that a lot of developers in crypto and especially DeFi want to stay anonymous. That’s OK but that makes it even more important to find credible information that allows you to assess who these people are.
- As a rule of thumb, the more info they are willing to share, the better.
Their partners
Having a lot of well-known partners and investors is a great sign for every crypto platform. Because in order to win reputable partners, they have to go through a strict testing and evaluation process. Don’t simply trust some logos on the platform’s website. Verify that they really do have cooperation by checking other sources as well (f.e. press releases).
Check external sources
Again, don’t only trust the marketing fluff they put on their website. Go through different 3rd party sources and find out what they have to say. The problem here is, though, that with new and very small projects it can be hard to find reliable information from other sources.
Check their social media channels
Social media channels are a great way of getting a feeling of the current status of a liquidity pool. These points are important:
- What kind of content do they share? While a little bit of hype is OK, you’d also want to see solid content about their project such as development news.
- How active are they? A lot of activity is good because it shows that they are committed to the project.
- Very important: What does user engagement look like? If it’s mainly unmoderated hype, people shilling coins, or a lot of complaints, then something might be wrong with this project.
Researching the liquidity pool’s KPIs
When it comes to picking the right pool, there are a number of key stats which you need to analyze first.
Volume
The higher the volume, the better. Because the pool only generates fees when many users swap the assets stored in it. Apy.vision is a website that offers free stats including 24h volume for many liquidity pools.
Liquidity
Also called reserves or total value locked (TVL), the size of the liquidity pool is important to ensure that the pool is not subject to price fluctuation. The higher the reserves, the more resistant it is to price slippage, which means the price ratio will also be more stable. In this context, you should also pay attention to the number of holders in the pool to ensure it is not made up of only a few whales. As that would mean if one of them exits the pool, the impact on the price ratios would be significant. Among other stats, you can also check the liquidity of pools via https://www.liquidityfolio.com/#
Volume/Liquidity
This KPI allows you to better estimate future APYs. Again, APY.vision is your friend to check this data for free. What you want to see here is a stable or increasing number as it means that volume is getting bigger (more users swapping) while the liquidity stays the same (more fees being paid out to fewer liquidity providers),
Impermanent Loss / Price Divergence of Tokens
As described above, the impermanent loss is one of the biggest risks coming with liquidity pools. Both APY.vision and liquidityfolio offer free information on this KPI.
Final Words
The contents covered in this article should give you a great starting point for identifying and analyzing credible liquidity pools that are safe and generate good returns. As with researching cryptocurrencies, it is important to not rush things and try to get as much data as you can in order to draw your conclusions.
Disclaimer: This article is sponsored by hi. It is intended for informational purposes only and should not be taken as financial advice. As always, before any buying or investment decision, you should do your own research.
